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Is Banking Turmoil Actually Helping the Fed?

As the Fed continues to grapple with its dual mandate of low unemployment and inflation, economic obstacles in the way of achieving such a mandate have largely manifested in two recurring headlines: persistently high levels of inflation and banking turmoil. On the one hand, in spite of an annual inflation rate in continuous decline since June 2022, current rates of 5 percent inflation still prove to be unsatisfactory in light of the Fed’s 2 percent inflation target, with markets expecting another interest rate increase at its May 2 FOMC meeting.

More rate hikes, however, also comes in spite of another purported issue gripping financial markets, that of banking turmoil over the last month. Yields on 2-year Treasury securities have slumped from 5.05 percent on the eve of Silicon Valley Bank’s bankruptcy to just under 4 percent as of writing, reflecting a flight to safety for large institutional investors in the primary market as well as other financial institutions in the secondary money market. Meanwhile, the Fed estimates that about $312 billion in deposits left the banking system over the month of March, as the KBW Nasdaq Bank Index, a proxy for the US’s banking sector health, is down from almost $110 per share at the start of March to a little over $82 on Monday.

At first glance, the dual issue of banking stress and high inflation may hint at a stagflationary paradox for the Fed, but what’s important to note is that fragility in financial markets has by no means translated into poor economic performance. Unemployment, the aforementioned target of monetary policy alongside inflation, has stayed relatively put at around 3.5 percent since last March, obvious signals of the metric remaining at its “natural rate.” This comes despite the fact that the first two quarters of 2022 put up negative real GDP growth, and the next and last two of the year rising but staying at relatively low levels. What this goes to show, however, is that US economic growth has proven lackluster before banking turmoil came into play, painting the case that there isn’t any newly developed reason for why the Fed should pause in its rate hikes, especially as other arenas for banking liquidity such as the bond market continue to recover.

Nonetheless, the other aforementioned shortcomings in the banking sector and their lack of translation to shortcomings in the wider economy may instead be assisting the Fed in its campaign to quell inflation. After all, the decreased circulation of liquidity in the financial system as a result of banking anxieties would have a disinflationary effect, reducing the supply of excess funds that may work into the wider economy and translate into inflation. In other words, we could be seeing a potential benefit of banking turmoil, its ability to reduce high inflation, without necessarily seeing it correspond with declining economic output, at least not yet. Although hindsight always proves 20/20, the Fed may have found an unlikely ally in recent bank distress.


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